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S&P Smacks Down a Big Argument for Active Management

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The evidence that actively managed mutual funds usually underperform their passively managed counterparts is growing. According to a new report from S&P Dow Jones Indices, this holds true not only for efficient markets like large-cap stocks but also for inefficient markets such as small-cap and emerging market equities where it’s commonly believed that active managers can deliver bigger gains.

Consider these statistics: over the past three, five and 10 years ended June 30, 2015, less than 27% of actively managed small-cap funds outperformed their benchmarks. The longer the time period, the lower the percentage of outperformance.

While 27% outperformed over a three-year period, only 21% did so over five years and 19% over 10 years. Even the one-year statistic was damning: 41% of small-cap funds underperformed. These stats are net of expenses and do not consider loads, which means that the underperformance is even greater overall.

The results were similar for emerging market equity funds, and sometimes much worse: only 27% outperformed over one year and 8% over 10 years.

Despite these stats, advisors should not necessarily shun all actively managed funds. “There are good active managers that can beat their benchmarks,” says Aye Soe, senior director of index research & design at S&P Dow Jones Indices.

But, she says, since the average return of both actively and passively managed assets must equal the aggregate market, “you can’t expect outperformance on a consistent basis,” especially after accounting for the extra costs of active management.

(The report does not identify individual funds.)

When it comes to long-term U.S. government bond funds, nearly 90% failed to outperform their benchmark — the Barclays Long Government Index — over one, three, five and 10 years, according to the S&P Dow Jones Indices data.

In comparison, well more than half of investment-grade short-, intermediate- and long-term corporate bond funds plus global income funds outperformed their benchmarks over three and five years.

Actively managed municipal bond funds – in the General and California categories – also beat their benchmarks rather consistently — over one-, three- and five-year periods.

In all three bond sectors – corporates, global and munis – credit analysis by fund companies is key to identifying potential winning investments. That’s also true for high-yield bond funds, but that category failed to outperform its benchmark consistently, according to the S&P Dow Jones Indices data. Perhaps that’s because the high-yield sector closely tracks equity markets and those actively managed funds underperformed overall.

Style Drift

Performance is not the only area where many actively managed funds disappoint. Many also consistently suffer from what’s commonly known as style drift, deviating from the expressed investment strategy, holding, say, many more large-cap stocks than a typical mid-cap equity fund would own. That would change the diversification mix that investors are counting on and presumably paying for. “Style drift is a major issue” for actively managed equity funds, says Soe. “Style shift and survivorship don’t get enough attention but should.” Survivorship refers to a fund’s longevity since funds can merge or be liquidated.

Among all domestic equity funds tracked by S&P Dow Jones Indices, only 53% maintained a consistent investment style over five years, and less than 35% did so over 10 years. Mid-cap value funds were the worst offenders. Twenty-one percent had a consistent style over 10 years, while 29% did over five years.

In contrast, bonds funds and real estate funds were the most consistent maintaining their investment styles.

The takeaway from all these statistics: “Look at the long-term data and what trends are there and then make a decision whether to go active or passive,” says Soe.

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